Winning The Fuel Wars

As I blogged in an earlier post, in the past few years, fuel has become quite the dominating force in airlines' cost structure. Fuel, as a percentage of airlines' operating expense, has almost doubled from ~13-14% in the first half of the decade to ~ 25% in the next. In terms of actual dollars, this means jumping from an average of ~1.5 cents per ASM to ~ 3.4 cents. No doubt, when asked recently to name the greatest risk for airlines in 2010, Gary Kelley, Chairman and CEO, Southwest Airlines said “That's easy. It's energy prices.”

Naturally, airlines have grown increasingly creative in managing their fuel needs with hedging fuel prices being a key component of this strategy. Fuel hedges, in fact, are considered the primary reason why Southwest continued to remain profitable even as other airlines struggled with record losses  -  clutching to every possible fee to keep them from drowning. In fact, some reports estimate that between 1998 and 2008, Southwest saved approximately $3.5 billion over what it would have spent had it paid the industry's average price for jet fuel. The following graph shows the price paid by the industry (all US carriers with revenue/yr > $20 Million) and that paid by Southwest for a gallon of jet fuel.  Notice the wide gap between 2003 and 2008.

The influence of Southwest's fuel hedges on its profitability can be gauged by comparing its 2008 domestic operating performance with that of other major carriers - Southwest was one of the only 3 major airlines to be profitable that year when fuel touched highs of $120/bbl.

But 2008 is history and the airline industry has certainly turned a corner in terms of profitability and business discipline – raising ancillary revenue, cutting capacity and consolidating. Lower fuel prices too have helped the airline industry get back to its feet. It would be interesting to see how airlines are doing on their fuel expenses in this new environment and which ones are winning this new round of fuel wars - just as Southwest did with 6 straight years of the lowest fuel costs among all the major carriers.

Comparing the average domestic fuel prices paid by the industry and the major players throws up some interesting results. Southwest, in fact, has the industry's highest domestic fuel cost at $2.39/gallon while US Airways has the lowest at $2.11/gallon – a difference of 28 cents. For an industry that consumed around 5,389 million gallons of fuel in the first 6-months of the year and paid $2.23 on average for a gallon of jet fuel that's a difference of $650 million – more than a billion dollars for the year.

In the first 6 months of 2010, American could have saved ~ $106 million had it bought jet fuel at US Airways' price/bbl, Delta $130 million, and Southwest about a whopping $200 million – now that's a lot of pocket change.  

  

Indeed, the sharp turn in fuel prices has thrown up an interesting winner – US Airways. Whether US Airways will be able to sustain this lead as Southwest did for 6 straight years from 2003 to 2008 remains to be seen. For now, US Airways sure is doing something right and the industry ought to take notice.  

This Time it's Different

Recently, the media have been buzzing about new found discipline among domestic carriers in introducing new capacity. "Capacity discipline,” as the experts call it. If indeed this is the case, the airline industry must be commended for finally putting its business model in order. Something it has been striving to do since de-regulation but has been unable despite downturns and bankruptcies.

On the face of it, claims of capacity discipline seem well-founded. Domestic capacity for the Jan – Jul period, as measured by available seat miles (ASM), is almost flat - down to 390 billion from 391 billion – a drop of 0.25%. This is after dropping around 9% from 2008 to 2009 for the same time period (Jan - Jul). In all, domestic capacity for Jan – Jul 2010 has fallen 9.3% compared to the same period in 2008. Experts suggest that this capacity discipline would be the foundation for a new and unprecedented era of airline profitability. The current consolidation, with a series of mergers and acquisitions, lends further credence to the argument that carriers would be more careful in extending capacity in the future.

However, the phenomenon of capacity discipline raises two interesting questions. First, are all carriers equally disciplined. And second, is this discipline more the result of a weak, uncertain economy than some newly found wisdom among airline leaders.  

The first question is relatively easily answered. A cursory comparison of ASMs from Jan-Jul YoY shows that most major carriers have kept capacity flat. However, “smaller” and predominantly "low-cost" carriers such as Alaska, Jet Blue and Airtran have increased capacity. Other large carriers, in fact the largest and the third largest – Delta-NW and American, have kept capacity fairly flat. Consequently, the brunt of capacity discipline has been borne by Southwest and legacy carriers such as United, US Airways, and Continental. 

As evident from the table, while Southwest and the four network carriers – American, United, Continental and US Airways reduced domestic capacity in Jan – Jul '10 by around 4.0 billion ASMs compared to Jan – Jul '09, the industry, shed only 982 million ASMs over the same period . In fact, Alaska, Airtran and Jetblue added almost 30% of the capacity shed by the large 5 carriers mentioned earlier.

Though too early to conclude much, carriers such as Jetblue and Airtran have traditionally been considered aggressive, well-run, better managed and more efficient (reflected in their relatively high valuations – Jetblue has a market cap of $2.01B on quarterly revenues of $939MM; Airtran market cap: $1.01B, revenue: $700 MM; Alaska market cap: $1.8B revenue $976MM). Would these carriers, especially after the proposed merger between Airtran and Southwest, sense reluctance on the part of the majors to add capacity and continue being aggressive and what would be the likely competitive response. How long would the larger carriers maintain discipline as their competitors add capacity will certainly be interesting to watch. Indeed, in an era of record load factors and yield, it is going to be hard for carriers to resist adding capacity.    

Though, one needs to understand that just as real estate is all about location location location, airline capacity is all about routes and yield. So a decrease in capacity by the majors could, in fact, bode well as they give up less lucrative, less strategic routes. However, to extend the same rationale to conclude that carriers would be disciplined while adding capacity on higher-paying routes doesn't quite seem consistent with the industry's past behavior. A recent artilce in BusinessWeek titled “ About the Airline Capacity Discipline...” by Justin Bachman on October 22, 2010 also raises the same concerns http://www.businessweek.com/lifestyle/travelers_check/archives/2010/10/about_that_airline_capacity_discipline.html. But then, all of us related to the industry hope this time it's different.   

Understanding airlines' cost structure.

The cost structure of airlines has undergone some drastic change in the last decade. The cost structure was relatively stable through the 1990's with the only major change being the steady decline in commissions – a likely fallout of passengers dealing with airlines more directly, possibly through the internet.

Since 1999-2000, however, this cost structure started to change quite remarkably. Starting 2002, the portion airlines spent on fuel started to rise steadily – this was a result of two developments. One, the steady rise in the price of aviation jet fuel (average jet fuel cost/bbl rose from $22 in 2000 to $128 in 2008). Second, airlines were able to extract concessions from unions during the spate of bankruptcies that followed 9/11 and the ensuing recession. As a result, fuel, as a percentage of total operational costs, almost doubled from 11.7% in 2002 to 22.4% in 2009. This was after touching 31.1% in 2008. In fact, for the three years from 2006 and 2008, fuel was in fact the single largest operating expense for airlines.

Noticeably, labor too is the large component in airlines' cost structure. Airlines spent anywhere between 3 and 3.25 cents on labor for each ASM. Labor thus accounts for almost a quarter of operational cost. While labor costs have decreased as a percentage of total operating expense, the amount airlines spend on labor per ASM has been fairly stable ranging from a low of 2.91 cents/ASM in 1990 (31.6% of operational expense) to 4.04 cents (38% of operating expense) in 2002. In 2009, airlines spent 3.26 cents/ASM accounting for 25.3% of their operating costs. This is in stark contrast to fuel which ranged from 1.34 cents/ASM in 1998 (9.9% of all operating expenses) to 5.87 cents/ASM (31.1% of operating expenses) in 2008. In 2009, airlines spent 3.59 cents/ASM in fuel, accounting for 22.4% of all operating expense.

The amount airlines spent on labor also reflects any productivity gains that may or may not have occurred, the impact of automation that may have made some labor obsolete (passengers checking-in online), policy changes – checked bag fee has resulted in substantial drop in checked bag volume requiring less labor. Similarly, fuel costs would reflect any improvements in the fuel efficiency of jets.

The third interesting cost item is transport-related expenses, which now account for 1.80 cents/ASM or 14% of operating expense. Transport-related expenses, according to the DOT, include transfer payments to express/regional carriers, costs associated with running a gift shop or serving liquor and food on-board or for performing maintenance for other airlines. This cost item in fact, almost doubled from 2003 to 2004 from 0.88 to 1.36 cents/ASM. Although the exact causes of this increase are not known, it is quite likely that increase is a result of a greater use of regional carriers to serve smaller, less strategic, routes.   

Tale Of The Same Industry?

“Our homework says you would start with comfortable custom-designed leather seats, and soothing cabin lighting to set the mood. Throw in WiFi on every flight, power outlets for your electronic gear, and loads of entertainment options, including 25 movies, videogames, live television, interactive Google Maps, seat-to-seat chat to make the time fly. Finally, make sure there is great food and drink around when you want it, not just when someone wants you to have it. Offer all of that at competitive fares and with an award-winning team that is focused on friendly service.” David Cush, President and CEO, American low cost carrier, Virgin America.

“The European consumer would crawl naked over broken glass to get low fares.” Michael O'Leary, CEO, European low cost carrier, Ryanair.

Hard to imagine that the two gentlemen above are talking about the same industry – the highly competitive, regulated and commoditized global aviation industry. The diametrically opposite approaches adopted by these two carriers, however, raises important questions about how would the aviation industry of the next 5 or 10 years look like? Would it move greater towards the bare bones approach advocated by Ryanair and most legacy carriers in the US or would carriers be able to rationalize their cost structures, improve efficiency, cut corporate flab, fly more fuel efficient planes and provide passengers quality product without nickeling and diming them?

The next few years would also define air travel, once again! Would passengers continue to view air travel as a commodity without much to differentiate among carriers except price – everything else staying the same or would they be willing to pay a premium either in hard dollars or greater loyalty for additional amenities, better inflight services, or friendlier staff among other things?

Coming back to Virgin and Ryanair, one wonders what could be behind such divergent views of the same industry? Obviously both can't be right or could they? “Conventional” wisdom definitely suggests

the industry moving towards the no-frills, bare bones structure with passengers having to pay for almost everything from seating together to checking their bags. Passengers too, with their almost religious focus on prices, have given airlines leeway to un-bundle amenities, even very basic ones, and to either start charging for them like seats with priority boarding or get rid of them completely like inflight-entertainment on long-haul domestic flights.

So what is behind Virgin America's vision of the industry? One of its biggest asset is its highly creative management team headed by David Cush and Donald Carty with Sir Richard Branson's entrepreneurship and innovativeness embedded in its DNA. Other is its relative youth compared to veterans such as American, other legacy carriers or even Southwest. Being young means cleaner, better looking, more fuel efficient planes, no integration issues that come with mergers especially union related issues that other, especially legacy carrier, have to face. Also Virgin comes without any baggage in terms of bad PR or customer service incidents in the past. Finally, a strong brand name in the form of Virgin with strong positive association with music (in the past) and cell-phones and air travel more recently and its characteristic youthful red color gives Virgin great positive brand recognition.

For now, however, it's anyone's guess what way the industry will evolve. Especially since one of biggest deciding factors, viz jet fuel prices, is notoriously hard to predict and can make a lot of smart strategies look ridiculously dumb in hindsight. Until then, it is going to be an interesting interplay of execution, vision, regulation, and the broader economy that is going to shape and re-shape the industry every passing day.